Thursday, January 24, 2013

Intel is Becoming Interesting

Intel (NASDAQ: INTC) came under pressure after its recent set of results but I think the stock is well worth taking a close look at. There are some interesting underlying things happening here. In summary, Intel is making the right strategic decisions now and if you believe that global GDP will be higher in the second half and you buy Intel’s guidance, then the stock is compelling.

Intel’s Tough Year

There are two reasons why Intel had a bad year leading into these results.
The first is that guidance was progressively lowered over the year, partly because global GDP forecasts were reduced. To be fair to Intel there isn’t much it can do about that and it’s certainly not alone in having hoped for a better second half to 2012.

The second reason is that there is a structural shift towards tablets and smartphones and away from PCs. Throw in the corporate drive towards desktop virtualization and it’s no surprise that PC sales are so weak. These changes are causing significant problems for Intel’s key customers Dell (NASDAQ: DELL) and Hewlett-Packard (NYSE: HPQ). Naturally, both of them were hoping for a lift from the release of Microsoft’s (NASDAQ: MSFT) Windows 8.

Again, it is hard to blame any of these companies for having such high hopes; after all, this has been how previous Windows cycles have gone. However, Windows 8 is not going to be as big a spur as initially hoped, and HPQ and Dell are going to have to realign their sales efforts. This is also a significant challenge for Microsoft, and pressure will be building on it to start to use its cash pile to make acquisitions. It needs more than Windows.

The combination of these factors has left Intel facing falling gross margins, rising inventories (which threaten average inventory selling prices because it needs to be reduced in a hurry) and the strategic challenge of realigning its business in order to get to the ‘processing market’ via tablets and smartphones.

Intel Responds

To its credit Intel has responded.
  • Inventories were reduced by $600 million as Intel took swift action, although this helped cause gross margins to decline to 58%
  • Capital Expenditures are being ramped up to $13 billion next year in order to keep technological leadership and prepare for tablet and data center growth
  • Intel is becoming more active in ultrabooks, tablets and smartphones
  • Gross Margins are forecast to be flat in Q2 and then get back to 60%+ in the second half
  • Intel is trying to become a selective foundry manufacturer
  • Data Center growth is expected to return to double digits going forward
Some commentators questioned the CapEx ramp up at a time when Intel’s sales growth is forecast to be in low single digits. Moreover it has seen costs and CapEx rise more than the top line recently. All of which is worrying, but what else can Intel do? It needs to invest in factories in order to service future growth, not least growth coming from shifting sales to new forms of computing like tablets, ultrabooks etc. This is what investors should want them to do. The real question is whether it will get it right. Will the future of computing be the kind of convertible PC/tablet that Intel would be ideally placed to service?

As for inventories and gross margins, I discussed how pivotal they are to Intel in an article linked here. Intel is doing the right things, although I would note that its positive gross margin guidance is somewhat dependent on a positive view of global growth in the second half of 2013. If Intel does what it forecasts then I’m sure the stock will be higher. History shows that you should buy Intel when its gross margins trough.

With regards to becoming a selective foundry manufacturer, it will never be a Taiwan Semiconductor (NYSE: TSM) but it doesn't need to be. Such activities will help utilize capacity and keep margins up for Intel. The likes of Taiwan Semi will always have scale on their side, but Intel is investing relatively more on their plants so there should be the opportunity to use these factories to their full potential via this sort of initiative.

Where Next for Intel?

The stock remains cheap but then challenged businesses usually are. The good news is that the company is making the right changes and it is churlish for analysts to jump up and criticize the affect on short term profitability or cash flows when companies do these things. What is more circumspect is Intel’s view that computing will take the direction of PC/tablet convertibles and the tardiness of its development of LTE solutions. If you share Intel’s view (and the fact that they take this view will be significant to future marketplace options) then it looks like a very attractive investment.  On top of it all you will be paid a 4% yield while you wait.

Investors can make their own mind up about the macro-environment, and this too is a crucial consideration before buying Intel. Naturally all of these things together will play out in the numbers so if Intel does what it says it will, then I expect the stock to be higher.

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